Light has pierced the gloom enveloping the industry after strong quarterly performances in several investment banks’ trading divisions, their chief profit drivers over the past decade. However, while the comeback has been impressive, some analysts are unsure about the sustainability of such results in the long term.

The fallout from the collapse of Lehman Brothers damaged banks’ trading arms in the final quarter of last year. Liquidity drained from the derivatives markets and primary issuance ground to a halt as investors reassessed counterparty risks. An added complication was widespread deleveraging and derisking that led to pared-down trading books and reduced risk appetite from the banks.

But this year, spreads – including the differences between the bid and offer price – have widened, in fixed income and currency markets in particular. That has meant some banks have made more per trade as they have been able to take advantage of the dislocation.

A return to higher trading volumes and higher margins for some banks appears to have helped stabilise the industry. But the nature of the business has changed. For the most part, any increases in trading have been in simpler products.

David Viniar, Goldman Sachs’ chief financial officer, said last week as the bank reported record revenues in its fixed-income, commodities and currency division: “The reduced levels of available risk capital created more market share opportunities and attractive margins across most of our franchise businesses, particularly in plain vanilla liquid products.”

However, analysts say the regulatory environment will make it more difficult for trading-based businesses to operate as before.

In a report published last week, a group of Bernstein Research analysts led by Brad Hintz in New York wrote: “For the banks and brokers, this suggests the capital-intensive trading businesses – which so dominated the firm’s growth strategies in the 2004-2007 period to be severely hamstrung. And with lower leverage and arguably more conservative regulatory capital rules applied to broker balance sheets, the proprietary trading businesses will generate lower returns on equity.”

The report said this meant the biggest banks would pursue higher margin, but less capital intensive, businesses. Other questions have been raised about the sustainability of these revenues over the long term. In a report published by UBS, analysts wrote that banks had to address issues such as value at risk, which is the measure of unexpected short-term loss on a trading book.

Related

Jerry del Missier, president of Barclays Capital in New York, said: “Issues around VaR, legacy balance sheets and capital requirements have yet to be fully ironed out. The outlook on that is unclear and in the near term those negative factors have to be considered in the context of the overall positive revenues that FICC divisions now generate.”

Risk was flagged by the Turner report from the Financial Services Authority, which suggested that tougher standards applied by regulators in the wake of the Lehman Brothers implosion should be made permanent. That would challenge banks’ ability to generate such large revenues from trading.

Del Missier said: “The fourth quarter of 2008 was a very challenging environment and we have now seen a snap back that has flattered some early 2009 results. Those levels are clearly not sustainable, but even if volatility does come off, the demand for hedging will still be very good for client franchises.”

In other words, FICC is back, but not as banks have known it. In the credit bull run up to the summer of 2007, the market was subject to consistently lower spreads. That meant less margin for banks and lower returns for investors. Investment banks introduced ever more complex products to capture that yield.

As the market has been rocked by the financial crisis, that process has become unnecessary. The unglamorous world of “flow” or client trading, which was historically a high-volume, low-margin business, has stepped into the breach.

The problem, identified by Viniar and others, comes when volumes return to a properly working market. This means a compression of spreads, and profits, in those simple products that have become a refuge for clients. Viniar said there would be some rewards as a result of the higher volumes, but it remains to be seen whether these revenue levels, sorely needed by banks, can be sustained. Goldman Sachs’ record quarterly revenues of $6.6bn (€5bn) in FICC in the first three months of this year was 34% higher than its previous record.

Pali Capital analysts said the drop in global hedge fund activity, a crucial component of Goldman’s business, might affect future trading revenues. In an equity research report published last week, they said: “Results have been driven by the tremendous growth of the OTC derivatives market.

Heightened regulation, a reduction in hedge funds and other alternative vehicles, and the onset of exchanges should weigh on both profitablility and volumes in this arena.”

In fixed income, much of investment banks’ revenues over the past quarter came from governments priming the fiscal stimulus pumps, adding a new source of primary issuance. JP Morgan last week reported revenues of $4.9bn from fixed-income trading alone while it reported $4.7bn from its institutional clients group.

Although more government bond issuance is expected short term, countries will eventually have to cut back. Those banks that have active FICC divisions should be able to increase their market share and benefit from the wider spreads available across asset classes.

Del Missier said: “You can’t just wave a magic wand now and hope to have an operating fixed-income business, it takes years of investment in people and technology to build a market-leading franchise, and if you don’t have that you are not going to be competing successfully. Those that have focused on the business and built such franchises will now be seeing a tremendous benefit.”

Analysts have also predicted strong FICC revenues for Credit Suisse and Deutsche Bank, which are due to report this week and on April 28 respectively.